The 2017 Tax Cuts & Jobs Act (TCJA) was generally kind to rental property investors, which may come as no small surprise given President Trump’s demonstrated affinity for using real estate ventures to minimize his own personal tax liabilities. Investors that were previously on the fence about owning real estate directly should consider the TCJA a direct invitation to add this tax-advantaged asset class to their portfolios.
While the TCJA tinkered with prized personal deductions, like those for home mortgage interest and local property taxes, the new tax laws were crafted to leave these deductions firmly in place for investment property. The good news gets even better when you consider that while 1031 exchanges for personal property were eliminated completely, no changes were made to investors’ ability to pursue 1031 “like-kind” exchanges for real property. Finally, bonus depreciation limits were increased from 50% to 100%, which allows for certain personal property and land improvements associated with real estate assets to be written off all at once instead of depreciated over time.
In this article, we’ll examine the key provisions mentioned above, along with some other lesser-known but still powerful deductions available to rental property owners. To explore further on your own, we recommend downloading two comprehensive resources that were developed by Stessa in partnership with The Real Estate CPA: New Tax Laws Summary and 11 Top Tax Deductions.
Super-Charge Your Depreciation
The ability to claim depreciation expense is among the most important tax deductions available to real estate investors and the TCJA effectively ups the ante by enhancing an often overlooked provision of the tax code. Typically, residential real estate assets held for investment purposes are depreciated over 27.5 years, which amounts to roughly 3.64% of the value attributed to the improvements being written off annually. By completing a cost segregation study to value personal property and “land improvements” separately, savvy investors have traditionally been able to segregate 20-30% of their cost basis and fully depreciate this portion over a radically shorter timeline of only two years. The TCJA further accelerates the bonus depreciation to make 100% of the value of the personal property and land improvements depreciable in a single year.
To take advantage of the new higher bonus depreciation limit, you’ll need sufficient current year passive income, which can be a challenge for many rental property investors. Be sure to explore this option further with your CPA. You may also want to figure out if there’s an easy path for you to become a “real estate professional” for tax purposes as that may allow you to use bonus depreciation to offset other non-passive income sources.
Steady On with Mortgage Interest, Property Taxes, & 1031 Exchanges
The so-called “blue state penalty” enacted under the TCJA caps two popular deductions that have historically been claimed mostly by residents of higher tax states. Mortgage interest on a primary residence is now only deductible on the first $750,000 of principal balance, while the combined deduction for state and local taxes (including property taxes) is now capped at $10,000 annually. Fortunately for rental property investors, neither change is applicable to property held for investment purposes. Real estate investors can continue to enjoy full deductions for mortgage interest and property taxes with no caps whatsoever. This is good news indeed and is another example of how the TCJA was structured to preserve much of what makes direct investments in real estate so attractive.
Another provision of tax law treasured by real estate investors was also left untouched under the TCJA. 1031 “like-kind” exchanges remain available to rental property owners looking to roll profits from the sale of one asset into a new purchase while deferring capital gains taxes. While the same stringent rules and timelines all still apply, 1031 exchanges remain one of the most powerful strategies for building and preserving wealth through real estate. That said, it’s worth noting that if you pursue the cost segregation study and take advantage of the bonus depreciation discussed above, this portion of your cost basis will be ineligible for protection under a subsequent 1031 exchange. You’ll pay capital gains and/or depreciation recapture upon sale, regardless of whether you complete a successful 1031 exchange. The rules are a bit complicated so it’s definitely worth discussing your particular situation directly with your CPA.
The 20% QBI Pass-Through Deduction: Do You Qualify?
Alongside significant reductions in corporate tax rates, the TCJA also introduced a new 20% Qualified Business Income (QBI) deduction for owners of pass-through business entities. Confusion reigned for many months after the TCJA was first enacted into law as this particular provision was short on specifics.
The IRS has since issued official guidance, including a detailed safe harbor provision for rental property owners. Investors who: 1) satisfy all five requirements of the safe harbor, 2) still have positive taxable income from their real estate portfolio after deducting all expenses including depreciation, and 3) remain under the taxable income limits overall, may qualify to deduct an additional 20% of their remaining passive income under the QBI provision.
The rules are somewhat complicated and need to be understood in the context of your specific tax situation. You’ll find details regarding the safe harbor provision and other requirements on pages 7-9 of the New Tax Laws Summary.
Opportunity Funds: A Viable Alternative to 1031 Exchanges?
One aspect of the TCJA that’s been getting a lot of press recently is the introduction of a new tax-deferred investment vehicle known as Opportunity Funds. Investors with otherwise taxable gains from the disposition of virtually any capital asset can roll the proceeds into an “Opportunity Fund” investment and enjoy partial deferment of capital gains taxes on this initial investment. In addition, further appreciation within the Opportunity Fund investment become tax-free if certain requirements and timelines are satisfied.
While the advantages of this new program to anyone selling stocks, bonds, or other traditional investments in 2019 are substantial and obvious, it’s less clear whether it makes sense for real estate investors. If you’ve recently sold an asset for a sizable gain you already have the option of shielding the gain from immediate taxation with a traditional 1031 exchange strategy. Over the long run, the 1031 approach in theory allows investors to kick the can down the road indefinitely, which is an option not available with Opportunity Fund investing. Your heirs can even enjoy a free step up in basis with proper estate planning, thereby avoiding capital gains taxes altogether. This is just one among many difference between Opportunity Funds and 1031 exchanges that you’ll want to consider when evaluating how to proceed after a successful asset sale this year. Check out pages 13-16 of the New Tax Laws Summary for a more in-depth discussion of Opportunity Funds & Zones and be sure to confer with your CPA for a professional opinion before making any final decisions.
Plenty of other juicy deductions remain available to rental property investors including the home office deduction, travel expenses including mileage, and qualifying educational expenses. Read more about these in the quick 4-page guide: 11 Top Tax Deductions for Rental Property Owners.
This article has been contributed by Devin Redmond from Stessa.